The Fed’s Risky Fill-the-Punch-Bowl Strategy
My mentor, the late
George Shultz, would often say “an economist’s lag is a politician’s nightmare.” Changes in economic policy take several quarters to affect the real economy. Politicians usually aren’t that patient.
The Federal Reserve announced a new policy doctrine almost a year ago. In essence, the Fed said it would no longer consider lags when making monetary policy, forsaking the policy of “pre-emption” that was standard under Fed heads
Paul Volcker, Alan Greenspan, Ben Bernanke and Janet Yellen. Jerome Powell’s Fed believes the party is just getting started and won’t remove the punch bowl until the fun is in full swing and the neighbors know it. Most in Washington can barely contain their enthusiasm for the new doctrine. Wall Street loves it too.</p><div> <p>Optimism about the future, however, should be matched by memories of the past. Real economic growth is surging more than it did during the Reagan years. U.S. government spending is growing at the fastest clip since World War II. The housing market is running hotter than it did in the runup to 2008. Financial-market ebullience is stronger and broader than during the dot-com boom at the turn of the century. And economic output will shortly surpass historic highs. The Fed might be right. The surge in prices and wages might be transitory. The widespread anecdotes of worker shortages and significant wage increases might not constitute a sustainable trend. Inflation expectations might be stable. Count me skeptical of the Fed’s convictions. The risks the Fed is taking with its winsome forecast are significant, and the consequences of policy error are severe. The Fed’s new doctrine is a catalyst for heightened concern. When announced at Jackson Hole in August, the goal of the Fed’s new doctrine was actually to unmoor inflation expectations, which were purportedly running too low for too long. The reanchoring of expectations—a little higher but not too much—is a far tougher task, especially amid the shifting seas of the post-pandemic economic resurgence. No other major central bank has adopted anything like the Fed’s new framework. The People’s Bank of China has already removed significant accommodation. The Bank of Canada announced meaningful steps toward normalization. The Bank of Korea signaled interest in somewhat tighter policy. I expect other Group of 20 central banks to move further from the Fed’s policy in the coming months. <div data-layout="wrap " data-layout-mobile="" class=" media-object type-InsetMediaIllustration wrap scope-web|mobileapps article__inset article__inset--type-InsetMediaIllustration article__inset--wrap "> <figure class=" media-object-image enlarge-image renoImageFormat- img-wrap article__inset__image " itemscope="" itemtype="http://schema.org/ImageObject"><div style="padding-bottom:159.06680805938493%;" data-mobile-ratio="159.06680805938493%" data-layout-ratio="159.06680805938493%" data-subtype="illustration" class="image-container responsive-media article__inset__image__image"> <img srcset="https://images.wsj.net/im-349785?width=140&size=custom_1886x3000 140w, https://images.wsj.net/im-349785?width=540&size=custom_1886x3000 540w, https://images.wsj.net/im-349785?width=620&size=custom_1886x3000 620w, https://images.wsj.net/im-349785?width=700&size=custom_1886x3000 700w, https://images.wsj.net/im-349785?width=860&size=custom_1886x3000 860w, https://images.wsj.net/im-349785?width=1260&size=custom_1886x3000 1260w" sizes="(max-width: 140px) 100px, (max-width: 540px) 500px, (max-width: 620px) 580px, (max-width: 700px) 660px, (max-width: 860px) 820px, 1260px" src="https://images.wsj.net/im-349785?width=620&size=custom_1886x3000" data-enlarge="https://images.wsj.net/im-349785?width=1260&size=custom_1886x3000" alt="" title=""/></div> <figcaption class="wsj-article-caption article__inset__image__caption" itemprop="caption"><span class="wsj-article-credit article__inset__image__caption__credit" itemprop="creator"> <span class="wsj-article-credit-tag"> Illustration: </span> David Gothard </span>
The resulting U.S. dollar weakness—in train since last fall—poses a host of dangers, including inflation risks. The Fed says it has the tools to stop an inflationary surge, but its new regime promises a tardy response. Late by design, the Fed would have to tighten policy more to stop an inflationary surge. Inflation is scarcely the sole or predominant policy risk. The scale of government spending and scope of government activity are unprecedented. Since the onset of the pandemic last February, the Fed has bought 56% of total Treasury issuance of $4.5 trillion. The Fed’s asset purchases represent 76% of the cumulative federal fiscal deficit. And the Biden administration is proposing a $6 trillion budget for fiscal 2022, about a third of which would be unfunded. The Fed says it’s still too early to slow its purchases of Treasurys and agency-backed housing debt. If the Fed doesn’t begin action imminently, it may be too late. Others will fund the nation’s profligacy even after economic growth slows and the debt burden grows. But what interest rate investors will demand for the privilege? Most large foreign buyers, including China, departed the Treasury auction market when the pandemic hit and haven’t meaningfully returned. Many foreign entities <a href="https://www.wsj.com/articles/beijings-bid-for-financial-supremacy-11609785257?mod=article_inline" target="_blank" class="icon none" rel="noopener">believe</a> the Fed is monetizing the fiscal expansion and expect the new policy experiment to end badly. Leaders in China are poised to capitalize on an American policy error. Others investors see the growing tensions between East and West, and are hedging their bets. The dustup in the recent meeting in Anchorage between China and the U.S. was merely prologue. The Biden administration might wonder if—in the absence of Fed intervention to keep interest rates exceptionally low—it can rely on the kindness of strangers to fund its grand ambitions. I worry the Fed has committed itself to a monetary “Brezhnev doctrine.” Leonid Brezhnev, the leader of the Soviet Union during the height of the Cold War, made clear that once another country adopts communism, it can never be allowed to revert. Maintaining a veneer of infallibility was more important to Moscow than accommodating changing circumstances. Dissent was strongly discouraged. Ultimately, the Brezhnev doctrine drained the Soviets economically until the system could no longer be sustained. And it drained the system ideologically so that a dangerous void was created in the aftermath. In the darkest days of the pandemic, Mr. Powell proved himself a nimble and capable crisis manager. But the crisis for which the Fed’s emergency tools were designed has long passed. The “V” shape of the economic recovery befits its proximate cause, the vaccine. The Fed risks walking through a one-way door. Mr. Powell’s performance at the next press conference—uttering precisely the right words in practiced, measured tones—is of modest importance. Talking about tapering is a sideshow, however well-publicized. What matters most now is what the Fed does, not what it says. The Fed should change its policy regime. It should stop buying mortgage securities immediately. Soon after, it should slow its purchases of Treasury debt. It should not tolerate Fed-financed fiscal expansion. It should unlock the handcuffs imposed by its novel doctrine and render an informed and humble judgment on the state of the economy and the attendant risks to the outlook. <em>Mr. Warsh, a former member of the Federal Reserve Board, is a distinguished visiting fellow in economics at Stanford University’s Hoover Institution.</em> <div data-layout="header " data-layout-mobile="" class=" media-object type-InsetMediaVideo header scope-web|mobileapps article__inset article__inset--type-InsetMediaVideo article__inset--header "> <figure class="media-object-video article__inset__video media-object-video--standard"> <figcaption class="wsj-article-caption article__inset__video__caption"> Potomac Watch: As Democrats redefine infrastructure to include climate change, green energy and union worker protections, Republicans push for a bipartisan bill that's not "socialism camouflaged as infrastructure." Images: Getty Images Composite: Mark Kelly </figcaption></figure></div> </div><p style="position: absolute;z-index:-1;top:0;left:-15000px;">Copyright ©2020 Dow Jones & Company, Inc. All Rights Reserved. 87990cbe856818d5eddac44c7b1cdeb8</p>